Is There an Enron Sitting In Your Portfolio?

Ask most investors -- even financial experts -- to explain what happened to Enron and they'll bring up those bizarrely named fake partnerships the company used to hide massive amounts of its debt.

The faux off-balance-sheet partnerships that Enron employees named after Star Wars characters and themes -- the Joint Energy Development Investment (abbreviated as JEDI), Kenobe Inc., Obi-1 Holdings and, of course, Chewco Investments -- would be funny if they weren't merely a sideshow compared with the monumental financial shenanigans taking place at the company.

Granted, silly names aren't a typical sign that there's something rotten with the state of a business. However, when a company's revenues surge from less than $10 billion to $100 billion in five years -- as Enron's did from 1995 to 2000 -- it's time to put down the champagne and start asking questions. After all, consider that the average company that's attained the $100 billion threshold (and there have only been a handful) took 25 years to hit that mark.

What was behind Enron's unbelievable growth

How did Enron pull the wool over so many investors' eyes? In business-speak, the company used some slick sleight-of-hand to change its revenue recognition policy to treat its boring utility business (which sold future delivery of natural gas) as a financial securities business. Using mark-to-market accounting (stay with me here), it treated its service contracts as tradable securities and booked the entire expected revenue from its service contracts immediately, instead of over the life of the contract.

Worse still, there were no actual markets (e.g., no actual customers) for many of the contracts Enron was supposedly selling.

Ultimately, Enron couldn't keep up with the fancy results it was reporting to investors -- later dubbed its "mark-to-make-believe" model -- and it ended in disaster for all of the investors that had been seduced by its unprecedented and fraudulent revenue growth.

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Oh, but Enron's Not the Only Bad Apple

Enron may be one of the more infamous, but it's just one of many examples of financial chicanery in recent corporate history -- Computer Associates, MicroStrategy, Satyam, and WorldCom are all once highly respected names that seared legions of investors.

More recently, Bank of America (BAC) agreed to an $8.5 billion settlement for its role in perpetuating mortgage fraud during the housing boom. Its stock price is still down some 80% from its 2007 high. And it doesn't seem like a week goes by without hearing of yet another U.S.-listed Chinese company being accused of some form of corporate malfeasance.

Examples of financial shenanigans are rich, ripe, and recurring. Learning to spot potential financial black holes -- which we'll help you do in this series -- will help you avoid bad investments and purge your portfolio of ticking time bombs.

Is your company monkeying with revenue reporting?

Investors usually don't think of a company's revenue as a likely source of financial shenanigans. Maybe that's why it's a popular hiding place for ne'er-do-wells to manipulate their results to meet or beat quarterly expectations. After all, investors assume that with revenue, it's what you see is what you get, right?

Not necessarily. With top-line revenue, it's all about recognition of that revenue. When demand starts to slow, aggressive management teams accelerate revenue recognition to give the appearance that customer demand is still strong. For example, a company may extend payment terms to customers who agree to make a purchase today instead of at a planned later date. Or it might begin to book revenue from a software license, even though the product hasn't been delivered to the customer yet.

By pulling revenue forward from future quarters -- money that hasn't yet been made -- companies are, in effect, stealing from their future to pretty up the present.

The problem with pushing revenues around is that recognizing them early dramatically increases the risk of an earnings miss down the road. The downward spiral can get ugly: We've all had the experience of watching one of our stocks plummet after it misses estimates.

6 signs of accelerated revenue recognition

Here are some red flags to watch for so you don't get dragged down by a company engaging in accelerated revenue recognition:

Red Flag

What It Tells You

How To Spot It

Receivables growing faster than sales

Accounts receivable measure how much cash a company is owed from customers. If receivables grow faster than sales, the company could be extending generous terms to entice more orders, or it could be having difficulty collecting the money it's owed.

Using the income statement and balance sheet, watch for trends in revenue and receivables growth. Ideally, you want receivables to grow at the same rate of or below sales.

Increase in days sales outstanding, or DSO

DSO measures the number of days in a quarter that it takes for a company to collect on its bills. Related to our receivables analysis above, a higher DSO is an indication of aggressive revenue recognition, poor cash management, or both.

To calculate DSO, divide a company's ending receivables with its revenue and multiply the result by the number of days in the period (e.g., 91.25 days for a quarter).

Use of percentage of completion, or POC, accounting

Under POC accounting, a company recognizes revenue on long-term contracts in proportion to the work completed, even though customers may have yet to be billed. Management could overestimate work completed and prematurely boost revenue.

Check a company's 10-K under revenue recognition policy and see if they are using POC accounting. Also watch for any sharp increases in unbilled receivables relative to revenue.

Big drop in deferred revenue

Software and subscription-based companies often receive cash in advance of delivering a product or service. A sharp drop in deferred revenue boosts revenue in the short term at the expense of future quarters.

Check a company's balance sheet and watch for any unusually large drops in deferred revenue.

Including inappropriate items in revenue

Proceeds from asset sales, investment gains, and interest on cash usually shouldn't be counted in revenue and can give a false sense of a company's operational strength.

Check the latest 10-Q or 10-K to see if any of these line items are being included in revenue. If so, remove them and reevaluate the company's revenue growth.

A change in revenue recognition policy.

Anytime a company changes the method or timing of its revenue recognition, alarm bells should be going off. What is the motive?

Check the most recent 10-K under revenue recognition policy for any mention of changes to methodology.

Next in this series, we'll help you spot earnings and cash flow red flags.

Motley Fool senior analyst Matthew Argersinger does not own shares of any of the stocks mentioned in this article. You can click here to see his holdings and a short bio. The Motley Fool owns shares of and has opened a short position on Bank of America.